The Comparative Advantage of the U.S. Shadow Banking System and the U.S. Dollar

Abstract

In the 2000s prior to the Global Financial Crisis (GFC) of 2008, European banks borrowed short-term dollar funds on liabilities side, in part, from the U.S., and then lent part of it back to invest in long-term dollar assets in the U.S. on assets side. What facilitated European banks to expand their USD-denominated balance sheets across the Atlantic in the 2000s, despite the creation of the euro in 1999? Compared to the amount of studies on why European banks expanded their balance sheets, few studies have indeed been done to analyze what determined the currency denomination of European banks’ balance sheets across the Atlantic in the 2000s. In this paper, we argue that European banks’ USD-denominated balance sheets across the Atlantic depended, mainly, on the comparative advantage of U.S. shadow banking system over one in the Eurozone. At financial market level, the full development of securitization and wholesale funding in U.S. shadow banking system appeared to provide European banks with the opportunities for profits-making there. This comparative advantage of U.S. shadow banking system could attract European banks to expand their USD-denominated balance sheets across the Atlantic in the 2000s. At institutional level, the evolution of U.S. Federal Reserve System (Fed) policy reinforced the comparative advantage of U.S. shadow banking system. During the U.S. housing bubble (2004-06), their unprecedented capacity of expanding USD-denominated balance sheets allowed European banks to overstretch USD-denominated balance sheets, achieving their higher return on equity (ROE). Importantly, their overstretch nature of USD-denominated balance sheets could contribute to strong demand for the privately-created debt securities and financial instruments in U.S., resulting in the dollar’s reign in shadow banking system in the 2000s. In conclusion, as far as the dominant position of the dollar in the shadow banking system, it seems natural to conclude that the U.S. dollar standard system has been as asymmetric as ever in the 2000s, in the contrary to the view that it has been less asymmetric than it once was, as Bernake [2015] insists.